Institutional theory

In Chapter Two it was noted that institutional theory ‘examines the processes and

mechanisms by which structures, schemas, rules and routines become established as authoritative guidelines for social behavior’ (Scott 2004, p. 409). The theory is a way of defining organisational structures and the social process through which these structures

develop (DiMaggio & Powell 1983; Meyer & Rowan 1977). Institutional theory is set within the dynamics of an organisation and its institutional values, in addition to the ceremonial structures that people within this dynamic display.

DiMaggio and Powell (1983) argued that organisations adapt over time and become similar to other organisations. This institutionalised isomorphism had its origins through ‘coercive’, ‘normative’ and ‘mimetic’ practices. Coercive isomorphism was established from regulatory pressures for convergence within companies, for example, the compliance with Corporate

Governance Principles and Recommendations of the Australian Stock Exchange (2007).

Normative isomorphism comes about through socialisation, for example, following ‘best practice guides’ in relation to corporate governance and audit committees. Thus organisations can have a tendency to follow best practice guides, rather than questioning the relevance of alleged best practices and their specific application within the culture of the organisation. Mimetic isomorphism comes about from following the leader, regardless of whether the leader’s practices are evidenced based. Best practice guides are illustrations of socialisation and normative practices and mimic governance practice without question.

i. Relevance for audit committees

The relevance of institutional theory for external stakeholders is that it confers a perception of trust and competency in the workings of the audit committee. In times of uncertainty or ambiguity, audit committee members can have a tendency to place a higher degree of emphasis on ceremony rather than monitoring under agency theory. Dillard, Rigsby and Goodman (2004) argued that institutional theory framework provided a useful insight into accounting practices in organisations, because these authors provided evidence:

…suggesting the importance of social culture and environment on the practice of accounting; the use of accounting practices as rationalizations in order to maintain appearances of legitimacy; and the possibility of decoupling these rationalizing accounting practices from the actual technical and administrative processes (p. 507).

This has broader implications for audit committees during an organisational crisis when there can be financial uncertainty including a lack of clarity in terms of cause, direction of change and long-term impact. Institutional theory implies a tendency to attract homogeneity into organisations (Tuttle & Dillard 2007). Their review of isomorphism in accounting research in the United States of America had some parallels for audit committees. They noted that when

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a field of study becomes entrenched, there is a tendency to conform to norms and values. This conservative approach has the effect of producing similarity for similarity’s sake, like normative and mimetic isomorphism.

Kalbers and Fogarty (1998) compared agency and institutional theory in an attempt to understand the effectiveness of an audit committee. They considered that the mere formation of an audit committee does not in itself achieve control of an organisation. They were unable to demonstrate a strong link however between audit committee effectiveness and agency factors and considered that effectiveness:

…emanates from sources close to the actual functioning of the audit committee. The formal empowerment of the audit committee appears to be designed for the consumption of external parties with some interest in the adherence to adequate forms of corporate control (p. 144).

Gendron et al. (2004) concluded that audit committees can fulfill both symbolic and substantive purposes. Their research concentrated on the following questions: (1) What matters are emphasised in audit committee meetings? (2) How do members evaluate them? and (3) How do members respond to management and external auditors during meetings? (p. 154). They concluded that practices which make the audit committee feel comfortable included the accuracy of financial statements and the quality of work performed by auditors. They also noted that the development of trust of external auditors was a fundamental aspect of work performance by the audit committee, although they did not make any assessment of reliance upon external auditors.

ii. Implications for audit committees

Implications of institutional theory for audit committees are the tendency for members to conform to the practices of audit committees in other organisations and, over time, display similar characteristics, for example, audit committees in Victorian local government.

Institutional theory also considers that audit committee members are more likely to come from similar backgrounds, which may be similar to management. DiMaggio and Powell (1983) and Powell and DiMaggio (1991) argued that institutions become similar over time through the process of isomorphism, as organisations adapt to those around them (Cohen, Krishnamoorthy & Wright 2008; Dillard, Rigsby & Goodman 2004; Gendron et al. 2004; Kalbers & Fogarty 1998, 1993; Tuttle & Dillard 2007). An example of this form of

isomorphism is the legislative requirement to have an audit committee under the Local

Government Act (1989), which results in councils in Victoria having audit committees,

irrespective of external and internal environmental pressures. Thus the act of merely having an audit committee in name only is not measure effectiveness or contribution to council.

3.3.2 Resource dependency theory

Resource dependency theory (Boyd 1990; Pfeffer & Salancik 1978) argues that shareholders and management rely upon the board of directors to: (1) access and manage scarce resources; and (2) set the strategy of the company with management. Under this theory, the role of the board is one of partnership as compared to monitoring under agency theory, and this formulates strategies and practices for the company. This perspective enhances the company’s future due to the board of director’s access to resources, networks and information. Cohen, Krishnamoorthy and Wright (2007) noted that none of the prior accounting studies had considered the duality of the board of directors performing simultaneous tasks of monitoring management, which is an agency perspective and actively setting corporate strategy, which is a resource dependency perspective (p. 92).

Their study evaluated where board roles were manipulated between strong and weak agency and resource dependency. They considered that the external auditor’s internal control risk assessments were impacted by agency and resource dependency roles. There was a significant variance between the group, which assumed a strong board role for both variables and the group, which assumed a weaker board role. The study noted that audit planning increased when the board was considered to be weak and ‘that auditors were willing to reduce their audit effort when the board is assessed as stronger on both dimensions’ (Cohen et al. 2007, p. 93).

The implications from this research suggest that auditors do not focus on the monitoring role of the board of directors (as per agency theory), but generally bring to bear a more complex and sophisticated understanding of company operations, the director’s roles, obligations and business risks (Cohen et al. 2007, p. 108). Cohen et al also stated that the implications ‘are that researchers who limit their perspective to the monitoring role of the board, based strictly on agency theory, may lose some of the richness that alternative roles of governance provide’ (2008, p. 185).

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3.3.3 Managerial hegemony theory

Managerial hegemony theory (Galbraith 1967; Kosnik 1987) argues that senior management appoint colleagues or contemporaries who will not impede the actions of management and will therefore be passive in governance processes. Under managerial hegemony theory, directors are dependent upon management for information and analysis of the company and the industry in which it participates. An outcome of this theory can mean a more symbolic compliance by the audit committee, rather than substantive oversight of management as would be the norm under agency theory. In conforming to managerial hegemony theory, the board of directors become limited to the ratification of management decisions and enhancement of executive compensation (Beatty & Zajac 1994; Westphal & Zajac 1994). Kosnik (1987) considered that in the context of hegemony theory, the board ‘is ineffective in alleviating conflicts of interests between management and shareholders’ (p. 166).

Westphal and Zajac (1994) examined long-term incentive plans as part of remuneration packages of chief executives between 1972 and1990. They noted that the use of such plans was particularly prevalent in companies with dominating or powerful chief executives or with poor financial performance. Beatty and Zajac (1994) provided an analysis of the relationship between the company’s risk profile and its form of executive management compensation, ownership and governance mechanisms. They concluded that there was an inverse relationship between levels of risk profile and the degree of incentive remuneration. Core, Holthausen and Larcker (1999) examined entrenchment of management and noted that chief executives earned larger remuneration packages when governance structures were weak or ineffectual. They concluded that: (1) companies with weak governance structures have higher agency problems; (2) chief executives with higher agency problems obtain higher remuneration packages; and (3) companies with high levels of agency problems, perform worse financially (pp. 372–3).

i. Relevance to the audit committee

Cohen et al. (2008) in their analysis of managerial hegemony theory stated that the analysis by Westphal and Zajac (1994) and Beatty and Zajac (1994) were two examples of the lack of independent monitoring by the board of directors and impairment of the stewardship function respectively. Kosnik (1987) noted that both agency and managerial hegemony theories have some similarities, to the extent that: (1) both theories assume a prevalence of corporate control and issues associated with conflict of interest; and (2) managerial hegemony theory

rejects directors as effective stewards of the company, whereas agency theory underscores their governance role.

ii. Implications

The implication of managerial hegemony theory (from the perspective of directors and the effectiveness of the audit committee) is that members of the audit committee will be compliant and less likely to ask probing questions of management. This also has implications for the external auditor in disputes with management pertaining to financial misstatements, as audit committee members have a propensity to side with management.

3.3.4 Behavioural theory

The research from a behavioural perspective recognises the interrelationship between the formal processes of an audit committee and the dimensions of informal relationships and power structures, for example: Beasley et al. (2009); Bedard and Gendron (2009); Brennan and Solomon (2008); Humphrey (2008); Turley and Zaman (2007).

Brennan and Solomon (2008) noted that accounting and finance research had traditionally focused on corporate governance, as measures of accountability. They also noted that the mechanisms of transparency within companies, particularly financial reporting, had been researched from the perspective of accountability of audit committees, internal audit and risk management as conduits to provide assurances about the quality of financial reporting (Brennan & Solomon 2008, p. 887). However, in the Australian local government context, the notion of effective corporate governance generally goes beyond accountability: it covers the development and use of infrastructure, creative solutions to problems, financial planning and strategic direction.

i. Relevance for audit committees

The contribution to the literature of Beasley et al. (2009) was their review of audit committee oversight processes in relation to: (1) acceptance and due diligence to serve on an audit committee; (2) selection of audit committee nominees; (3) meeting processes; (4) oversight of financial reporting processes; (5) oversight of internal and external audit processes; and (6) benchmarking of audit committee processes (Beasley et al. 2009 pp. 77-78). These authors found that many audit committee members ‘strive to provide effective monitoring of financial

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reporting and seek to avoid serving on ceremonial audit committees’ (Beasley et al. 2009, p. 66). However, they concluded that there was some evidence of both ‘substantive monitoring and ceremonial action’, which agency theory or institutional theory could not properly explain. They noted that whilst DeZoort et al. (2002) had described audit committee effectiveness in terms of: (1) composition; (2) authority; (3) resources; and (4) diligence, their ‘interviews reveal that financial expertise (composition) is receiving a great deal of attention in the post-SOX environment’ (Beasley et al. 2009, p. 112). Their research also highlighted the importance of the audit committee asserting authority, for example, the management of the internal audit program and external auditors having access to key internal and external stakeholders and spending sufficient time reviewing information presented to the audit committee (Beasley et al. 2009, p. 112).

Bedard and Gendron (2009) reviewed select audit committee literature between 1994 and 2008 to evaluate whether audit committees can deliver against increasing regulatory and societal expectations. The significance of their work related to the extension of audit committee effectiveness with regard to quality of financial reporting to what they called ‘a perceptual perspective from the viewpoint of the actors involved’ (Bedard & Gendron 2009, p. 3). They noted that of the ninety-one papers produced, there were twenty papers which emphasised a psychological approach, with another five having a sociological perspective. These papers had been formulated from a psychological perspective and explored issues pertaining to expertise, credibility, negotiation, persuasion and accountability of the audit committee, whilst the papers formulated from a sociological perspective explored notions of power and organisational theory. Whilst the majority of papers (sixty-six out of ninety-one or 73%) were from a legal or regulatory perspective and mostly from an agency perspective, it was relevant to note the emerging literature from sociological and psychological schools of thought, which could be used to explain or interpret behaviours of audit committee members and management attendees at audit committee meetings.

ii. Implications for audit committees

Turley and Zaman (2007) also noted the predominance of the agency approach to rationalise behaviours of audit committees. They considered that the empirical evidence of the nexus between financial reporting and audit committee variables, for example, frequency of meetings and financial expertise of members, was mixed. They concluded that the ‘complexities of organisational settings, power relations around and within corporate entities

and the nature of business as social systems are not properly represented in simple agency models’ (Turley & Zaman 2007, p. 767). Further, in addition to the formal process of audit committees, governance outcomes were significantly influenced by the informal processes which underpin an organisation and power relations. They noted that these dimensions can ‘interact with each other in producing governance outcomes and it is difficult to isolate the effect of one from another’ (Turley & Zaman 2007, p. 785).